With a gradual recovery in the overall economy, the homebuilding
industry is finally seeing signs of stabilization in 2012. The
downturn during 2006-2007 had hIt the homebuilding sector hard.
We believe that the housing market is starting to benefit from an
increase in employment rates and higher consumer confidence. Houses
are more affordable now as mortgage loans come with relatively low
interest rates while renting becomes more expensive.
Thus, most homebuilding companies are witnessing better
year-over-year growth in revenues, driven by an increase in new
home orders and average selling prices. Backlogs (number of
homes under sales contracts at the end of the year) and homes
delivered are also climbing year over year.
Moreover, improving homebuilding revenues combined with tight cost
control by most homebuilders are boosting margins. The large
discounts and incentives offered in response to declining demand
and an oversupply glut are gradually being called back.
The National Association of Home Builders/Wells Fargo Housing
Market Index (HMI) rose by five points to 29 in May 2012 from the
previous month, its strongest reading since May 2007. The
improvement in this index suggests an increased demand for housing
driven by high consumer confidence, an improving job market and low
interest rates.
Housing Recovery Slow
The last few years have seen a very fragile housing market. The
downturn in housing — aggravated by an overall weak economy, high
unemployment rates, low consumer confidence, rising interest rates
and tightened mortgage-lending standards — weighed down on
homebuilders.
Declining demand for new homes and an excess of supply in the
market in 2011 drove homebuilders to make large concessions in
prices, largely hurting profitability. Homebuilders’ sales and
profit margins had dropped dramatically from peak levels in 2006.
As discussed above, there have been signs of a nascent improvement
in the housing market so far in 2012. However, homebuilders have
cautioned that the process of stabilization is at best erratic and
not adequately broad-based.
The housing market improvement has been uneven across the country.
Most of the gains have, by and large, been observed in high-end
communities. Moreover, the industry still faces significant
challenges from an oversupply of foreclosed homes and short-sale
homes. Overall demand still remains constrained due to tight credit
standards which make it difficult to obtain loans for home buying.
A speedy housing recovery is unlikely and it will take some time
before the markets fully recover.
Progress in High-End Communities
The average selling prices (ASPs) are improving for most large-cap
homebuilders due to changes in the community/product mix. ASPs have
gained from increased sales in high-end communities of California,
Arizona, Colorado and Florida where home prices are generally
higher.
Given the scenario, large builders are taking away share from other
undercapitalized small/medium-sized private builders on the back of
overall housing demand, stronger capital and better land positions.
Lennar Corporation
(
LEN
) strategically focuses on acquiring new home sites that would
boost margins and percolate down to the bottom line. The company
focuses on high-margin, well-positioned communities and avoids
fringe or tertiary markets where price is the only driver. The
company’s focus on quality instead of quantity is benefiting
margins and boosting new sales orders.
KB Home
(
KBH
) has started rolling out communities in highly desirable
submarkets, which allows it to sell larger, higher-priced homes,
driving up the ASP. KB Home is also targeting higher income,
first-time and move-up buyers — all of whom are more inclined
toward buying a new home rather than buying a foreclosure.
PulteGroup Inc.
(
PHM
) is continuously evaluating its assets and prioritizing markets
and projects in order to appropriately allocate capital. The
company is divesting lower-margined projects and exiting
non-performing communities which no longer fit in the company’s
operating strategy. Such a policy frees up cash to invest in other
potential opportunities which generate higher returns.
Cost Saving Initiatives
Most housing companies resorted to cost reduction strategies in
order to cope with the challenging industry conditions like a
sluggish US homebuilding industry and raw material cost inflation.
Most of these companies have taken action to improve their
operating and financial performance.
PulteGroup made significant workforce reductions and is also
aggressively working to reduce overhead costs. In 2011, the company
consolidated its field organization and select corporate functions.
It also consolidated its regional operations in Arizona, Florida,
New York and New Jersey and merged its West and Central area.
Management’s concerted efforts to reduce overhead costs pulled down
selling, general and administrative (SGA) expenses
substantially in 2011. This subsequently acted as a tailwind for
margins. The company is also adjusting the contents of its homes
and building smaller floor plans to suit the needs of
cash-constrained Americans.
Home improvement products-maker
Masco Corporation
(
MAS
) took initiatives like business consolidation, system
implementations, plant closures, improvement in the global supply
chain and headcount reductions to contain costs. These initiatives
are expected to result in about $150 million of gross cost
reduction before inflation in 2012.
Construction aggregates maker
Vulcan Materials Corp.
(
VMC
) has invested in a new Oracle-based ERP and Shared Services
platform which allowed the consolidation of the company’s eight
divisions into four regions. The system also streamlined its
support functions, thereby reducing related positions and overhead
costs.
The company has also announced two other initiatives: a Profit
Enhancement Plan and planned asset sales, in order to improve
earnings and cash flows, pay off debts and thereby strengthen its
overall credit profile.
The Profit Enhancement Plan is designed to reduce costs as well as
enhance profitability by streamlining the management structure over
the next 18 months. The plan is expected to improve EBITDA by $100
million on an annual basis by 2014.
Under the planned asset sale, the company plans to divest its
non-core assets over a period of 12 to 18 months in order to
improve the company’s liquidity position and earnings. These sales
are expected to generate after-tax net proceeds of $500 million.
Though cost-saving initiatives will hurt earnings in the near term,
the overall growth profile of the homebuilding companies will get a
boost over the long haul when the housing market fully recovers.
OPPORTUNITIES
We do not have an Outperform recommendation on any housing company.
Despite the Neutral recommendations, we have a positive view on
large homebuilders like
Lennar
(
LEN
),
DR Horton, Inc.
(
DHI
) and
Pulte Group
(
PHM
) which are showing impressive improvement in tandem with a
stabilizing housing industry.
DR Horton has started the financial year on a strong note despite
macroeconomic uncertainties and housing conditions remaining soft.
Growth in double digits was observed in net sales orders, homes
closed and sales order backlog in both the first and second
quarters of 2012. Management expects stronger home closings in the
third and fourth quarters of fiscal 2012 as demand for new homes
historically ramp in the latter half of the year.
The company’s efforts to date in investing capital in growth
projects, managing inventory levels efficiently, improving gross
margins and controlling SGA and interest costs are expected to
reap rewards. DR Horton’s strong cash flows can be used to pay back
outstanding debts and lower interest costs.
The company’s strong cash position and low debt/capital ratio also
allow it to make opportunistic land purchases even during a
downturn, thus giving it a significant competitive advantage. The
stock carries a Zacks #2 Rank (short-term Buy rating).
Lennar also witnessed increased homebuilding revenues in the first
quarter of 2012, driven by price increases and improved net order
growth. We believe the company is performing better than its peers
by increasing sales prices, reducing incentives, improving volumes
and investing in well-positioned, high-margined communities. The
company offers a diversified line of homes for first-time, move-up
and active adult homebuyers which can be availed in a variety of
environments ranging from urban infill communities to golf course
communities.
The Rialto business wing is progressing well and has untapped
growth opportunities as the market continues to improve. Rialto
Investments is involved in the acquisition of portfolios of, or has
interests in portfolios of, distressed debt instruments and
foreclosed properties. The stock carries a Zacks #2 Rank
(short-term Buy rating).
Regarding Pulte Group, we are encouraged by the company’s
initiatives to improve its operating and financial performance.
These initiatives include managing margins, overhead and inventory,
and improved capital allocation for more efficient use of funds.
The strong cash balance allows the company to retire its
outstanding debt, thereby improving the company’s leverage.
Pulte, which includes brands like Pulte Homes, Centex and Del Webb,
also reported improvement in net orders and average selling prices
in the first quarter of 2012 and boasted of a better product mix,
comprising increased home closings of steeply priced move-up homes.
The stock carries a Zacks #3 Rank (short-term Hold rating).
Other than the large homebuilders, we have a favorable opinion on
Masco
(
MAS
), which holds a leading position in the home improvement market.
We are encouraged by Masco’s leadership brands (like KraftMaid and
Merillat cabinets, Delta and Hansgrohe faucets, Behr paint and
Milgard windows), continued focus on product innovation and cost
improvements.
We also like the company’s initiative to restructure its business
by exiting less profitable and
underperforming assets. We are encouraged by the company’s strong
first quarter results. The stock carries a Zacks #3 Rank
(short-term Hold rating).
Vulcan Materials
(
VMC
), which is the largest producer of construction aggregates in the
US, derives more than half its revenues from public sector
construction projects, such as bridges, dams and roads. Generally,
public sector spending is much more stable than the private sector
because these are less affected by general economic cycles, thus
giving Vulcan a significant competitive advantage.
We are encouraged by the company’s better-than-forecasted results
in the first quarter, in particular the impressive performance of
the Aggregates segment, which is slowly gaining momentum. We also
like the company’s expanded cost initiatives which will improve the
overall credit profile of the company in the long run. The stock
carries a Zacks #3 Rank (short-term Hold rating).
WEAKNESSES
We advise investors to avoid names that have reported net order
declines in the latest quarter. These homebuilders also show signs
of slackening profitability.
Going by this rule, it is best to avoid
KB Home
(
KBH
) even though we have a Neutral recommendation on the stock. A
decline in net orders and compressed gross margins widened KB
Home’s loss in the first quarter of 2012. Housing revenues, homes
delivered and average selling prices declined significantly from
prior-quarter levels. Net orders declined due to mortgage delays
which triggered order cancellations.
We believe that KB Home’s mortgage financing issues create a
short-term overhang for the company and will hurt net orders and
backlog conversions at least for the next 2-3 quarters. The stock
carries a Zacks #3 Rank (short-term Hold rating).
Another company which announced unimpressive results this quarter
was
Meritage Homes Corporation
(
MTH
). The company recorded lower-than-expected revenues and
wider-than-forecast loss in the quarter. The stock carries a Zacks
#3 Rank (short-term Hold rating).
KB HOME (KBH): Free Stock Analysis Report
LENNAR CORP -A (LEN): Free Stock Analysis
Report
MASCO (MAS): Free Stock Analysis Report
MERITAGE HOMES (MTH): Free Stock Analysis
Report
PULTE GROUP ONC (PHM): Free Stock Analysis
Report
VULCAN MATLS CO (VMC): Free Stock Analysis
Report
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